Legal Updates

Penalty Clauses in Contracts - all change after 100 years

It is common to see clauses in commercial contracts which seek to fix the damages which will be payable if one party breaches their contractual obligations. Sometimes the figures will be broadly what the parties would expect the financial loss caused by the breach to be. In other cases, the figures will be widely excessive and the suspicion will be that the person drafting the contract was seeking to impose an additional incentive on the other party to comply with the terms of the contract to avoid being heavily penalised.

For over a century Defendants seeking to defend this type of damages claim have been arguing that such clauses are unenforceable because they are “penalty clauses”. And Claimants have been responding that they are nothing of the sort, but are simply clauses setting out a “genuine pre-estimate of loss” which are fully enforceable. This legal argument follows the 1915 decision of House of Lords in Dunlop Pneumatic Tyre Co Limited v New Garage & Motor Co Limited. In that case, the House of Lords held that a contracting party cannot include a term in a contract which is designed as a financial threat or punishment to intimidate the other side into performing the contract. It was only acceptable to include a clause fixing future damages if the amount of damages payable was a genuine estimate by the parties of the financial loss they expected the innocent party to suffer.

Curiously, it took one man’s crusade to overturn an £85 parking fine for the England’s highest court, now called the Supreme Court, to revisit this area of contract law. This case, ParkingEye v Beavis (heard alongside another similar case), has attracted plenty of media coverage, partly because the claimant, Mr Beavis, funded his legal costs through crowd-funding, with donations coming from many people sympathetic to his cause. Mr Beavis’ complaint was that the £85 parking fine he received for overstaying the two hours free parking at a private car park was excessive and therefore unenforceable as a penalty clause. Those of you expecting a fairytale ending will be disappointed as Mr Beavis lost his case. The Supreme Court held that the £85 parking fee was not excessive.

The Supreme Court did, however, take the opportunity to review this historic area of law, which they had described as having become “a prisoner of artificial categorisation”.

Mr Beavis’ claim was interesting because the car park did not suffer any direct financial loss as a result of his overstaying his 2 hours free parking. This meant that the £85 parking fine (which effectively was the damages claimed against Mr Beavis under the contract allowing him to use the car park) could not be a genuine pre-estimate of future loss. Instead, the Court considered whether the parking fine was an excessive or wholly disproportionate way of protecting the legitimate interests of the car park operator. They identified two such legitimate interests; the need to manage the efficient use of parking spaces for the benefit of the shopping centre it served; and the need to provide an income stream to enable the car park operator to run the parking scheme and make a profit. They then considered whether the level of parking fine was excessive having regard to those legitimate interests and decided that they were not, ruling against Mr Beavis on the claim. Unhelpfully, they did not give any guidance on what would have been an excessive penalty in this situation.

So whilst it is still the case that penalty clauses are unenforceable, the law has definitely changed. No longer is the focus on whether the level of damages fixed in the contract represents the parties’ genuine belief of future loss. Instead, the primary question is whether the purpose of the clause is to penalise. The test is whether the payment (or other remedy) imposed when the contract is breached is “exorbitant” or “out of all proportion” to the innocent party’s interest in the performance of the contract. It is too early to assess whether this will prompt a widespread change in commercial practice, but it is certainly the case that there are greater opportunities now for using carefully draft damages clauses to fix future claims, particularly in cases where there is no obvious financial loss caused to the innocent party but they nonetheless have a clear interest in making sure the term is honoured.

Clarkslegal, specialist Dispute Resolution lawyers in London, Reading and throughout the Thames Valley.

For further information about this or any other Dispute Resolution matter please contact Clarkslegal's dispute resolution team by email at disputeresolution@clarkslegal.com by telephone 020 7539 8000 (London office), 0118 958 5321 (Reading office) or by completing the form on this page.